Tuesday, October 21, 2014

Learning About Growth from Austerity

MILAN – In a recent set of studies, Carmen Reinhart and Kenneth Rogoff used a vast array of historical data to show that the accumulation of high levels of public (and private) debt relative to GDP has an extended negative effect on growth. The size of the effect incited debate about errors in their calculations. Few, however, doubt the validity of the pattern.

This should not be surprising. Accumulating excessive debt usually entails moving some part of domestic aggregate demand forward in time, so the exit from that debt must include more savings and diminished demand. The negative shock adversely impacts the non-tradable sector, which is large (roughly two-thirds of an advanced economy) and wholly dependent on domestic demand. As a result, growth and employment rates fall during the deleveraging period.

In an open economy, deleveraging does not necessarily impair the tradable sector so thoroughly. But, even in such an economy, years of debt-fueled domestic demand may produce a loss of competitiveness and structural distortions. And the crises that often divide the leveraging and deleveraging phases cause additional balance-sheet damage and prolong the healing process.

Thanks in part to research by Reinhart and Rogoff, we know that excessive leverage is unsustainable, and that restoring balance takes time. As a result, questions and doubts remain about an eventual return to the pre-crisis trend line for GDP, and especially for employment.

What this line of research explicitly does not tell us is that deleveraging will restore growth by itself. No one believes that fiscal balance is the whole growth model anywhere.

Consider southern Europe. From the standpoint of growth and employment, public and private debt masked an absence of productivity growth, declining competitiveness in the tradable sector, and a range of underlying structural shortcomings – including labor-market rigidities, deficiencies in education and skills training, and underinvestment in infrastructure. Debt drove growth, creating aggregate demand that would not have existed otherwise. (The same is true of the United States and Japan, though the details differ.)

Government is not the sole actor in this. When the deleveraging cycle begins, the private sector starts to adjust structurally – a pattern clearly seen in the data on growth in the tradable side of the US economy. Muted wage growth increases competitiveness, and underutilized labor and capital are redeployed.

How fast this happens partly depends on the private sector’s flexibility and dynamism. But it also depends on the ability and willingness of government to provide a bridging function for the deficiency in aggregate demand, and to pursue reforms and investments that boost long-term growth prospects.

If public-sector deleveraging is not a complete growth policy – and it isn’t – why is there so much attention on fiscal austerity and so little action (as opposed to lip service) on growth and employment?

Several possibilities – not mutually exclusive – come to mind. One is that some policymakers think that fiscal balance really is the main pillar in a growth strategy: Deleverage quickly and get on with it.

The belief that the fiscal multiplier is usually low may have contributed to underestimation of the short-run economic costs of austerity policies – and thus to persistently optimistic forecasts of growth and employment. Recent research by the International Monetary Fund on the context-specific variability of fiscal multipliers has raised serious questions about the costs and effectiveness of rapid fiscal consolidation.

Estimates of the fiscal multiplier must be based on an assumption or a model that says what would have happened in the absence of government spending of some type. If the assumption or the model is wrong, so is the estimate. The counterfactual needs to be made explicit and assessed carefully and in context.

In some countries with high levels of debt and impaired growth, fiscal stimulus could raise the risk premium on sovereign debt and be counterproductive; others have more flexibility. Countries vary widely in terms of household balance-sheet damage, which clearly affects the propensity to save – and hence the multiplier effect. Uncertainty is a reality, and judgment is required.

Then there is the time dimension. If infrastructure investment, for example, generates some growth and employment in the short to medium term and higher sustainable growth in the longer term, should we rule it out because some estimates of the multiplier are less than one? Similarly, if fiscal stimulus has a muted effect because the recipients of the income are saving to restore damaged household balance sheets, it is not clear we want to discount the accelerated deleveraging benefit, even if it shows up in domestic demand only later.

Policymakers (and perhaps financial markets) may have believed that central banks would provide an adequate bridging function through aggressive unconventional monetary policy designed to hold down short- and long-term interest rates. Certainly central banks have played a critical role. But central banks have stated that they do not have the policy instruments to accelerate the pace of economic recovery.

Among the costs and risks of their low-interest-rate policies are a return to the leveraged growth pattern and growing uncertainty about the limits of a central bank’s balance-sheet expansion. In other words, will the elevated asset values caused by low discount rates suddenly reset downward at some point? No one knows.

Countries are subject to varying degrees of fiscal constraint, assuming (especially in the case of Europe) a limited appetite for unlimited, unconditional cross-border transfers. Those that have some flexibility can and should use it to protect the unemployed and the young, accelerate deleveraging, and implement reforms designed to support growth and employment; others’ options – and thus their medium-term growth prospects – are more constrained.

All countries – and policymakers – face difficult choices concerning the timing of austerity, perceived sovereign-credit risk, growth-oriented reforms, and equitable sharing of the costs of restoring growth. So far, the burden-sharing challenge, along with naive and incomplete growth models, may have contributed to gridlock and inaction.

Experience can be a harsh, though necessary, teacher. Growth will not be restored easily or quickly. Perhaps we needed the preoccupation with austerity to teach us the value of a balanced growth agenda.

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  1. CommentedFlint O'Neil

    Accumulating excessive debt for public services tapping into private sector savings to fund the deficits had no net effect on wealth. Surely the inverse relationship is true when the repayments begin as money is pumped back into the system as repayments. In other words, deleveraging of the public sector under normal economic conditions where no output gap is present should accelerate leveraging in the public sector

    Your logic needs specification because the only reasons I can extrapolate from this paragraph is that foreign countries are supplying credit, or that there is an output gap during the leveraging times (Untrue)

      CommentedFlint O'Neil

      Whoops. I meant deleveraging of the public sector in absence of output gap should accelerate leveraging in PRIVATE sector

  2. CommentedManuel Gomes Samuel

    Was deleveraging necessary in Southern Europe? Bearing in mind the assumption that debt escalated in the last decade in the European periphery and that productivity was more or less stalled in the same period, there would be no apparent way to reassure the financial markets that Club-Med economies would ever gain pace to foot the bill without deleveraging. But if we look to the most consensual theory (notably Minsky and Geanakouplos) and with hindsight to Argentina, between 2002 – 2008, and Mexico (1982 – 1992), just to name some few examples, we would clearly perceive that deleveraging in Southern Europe following the global bear market of 2008 would be extremely risky. The 90 % public debt threshold of Rogoff/Reihardt (RR) was mostly based upon data and assumptions that could hardly be used for the Euro zone specific conditions (no single fiscal policy, no banking union, no mutual public debt issuance, etc, etc). RR estimated that “for levels of external debt in excess of 90 percent of GDP, growth rates are roughly cut in half”; assuming that their theory is credible (let’s leave aside the brouhaha related to their alleged Excel mishandling), one can concur that the time was ripe for deleveraging in Southern Europe (and mostly elsewhere). This should be scientifically indisputable but the question here is timing and deleveraging implementation. All modern deleveraging theories assume that the correction period has a negative impact on GDP growth and employment (as an evident aftershock of belt-tightening). The common assumptions from the scientific community (see Mexico, Chile and Argentina) point out to failures from politicians in heeding advice to soften the “earthquake” provoked by a sudden contraction in the internal market of a country. The same is happening in Europe. If deleveraging is necessary at some point, the EU political masters did not see that it was evident that the Troika imposed belt-tightening would flatten economies that were already in an urgent need to reform (remember, for instance, Alesina and Giovazzi wake-up call in 2008). Now everybody seems to have woken up to the nightmare in Southern Europe, the years lost, the lost generations, the market share gains by non-EU economies and so one and so forth. All of a sudden, the fiscal hawks rushed to read Bradford DeLong and Lawrence Summers. Possibly deleveraging in Southern Europe could only be carefully pursued in the presence of a single fiscal policy, a banking union, mutualized debt and true European solidarity, to name just some few conditions. Without truly competitive business conditions, no entrepreneur in Seville, Porto, Thessaloniki or any other affected area would enjoy a favorable business environment to invest and create jobs.

  3. Commentedsrinivasan gopalan

    Prof. Spence piece exquisitely brings out the fact of the universal truth that ills have to be got over only through pills-- no doubt countries administering the bitter pill of austerity remain in an unenviable predicament as to how to bring about growth without endangering the fisc front. If economics is touted to be behavioural science, it is time people suffering the ills of debt-driven and credit-card induced prosperity leraned to swallow the pills of austerity in order that they should emerge leaner and fitter to face the challenge and emerge triumphant in the end. Alternatively, use the lean phase of low growth to bolster the underlying values of life by being abstemious in living so that medium-to-long-term prospects get better and posterity should appreciate the sacrifice of the extant generation. There is no gain without pain nor there is growth without self-abnegation in the optimistic belief that better days would return and the global economy would revert to its pre-crisis growth level, once headwinds blow over. This is the long and short of the various economic jargons the erudite professor has employed to convince the heathen brethern who brook no austerity! G.Srinivasan, Journalist, New Delhi, India

  4. CommentedZsolt Hermann

    What I do not understand is that we talk about austerity as if it was a free choice decision, when politicians, experts could have chosen measures boosting growth, and instead they choose austerity.
    And all this in capitalistic countries, many times by conservative governments for whom growth and increasing profit is everything.
    People started to "choose" austerity because they had no other options, because the constant quantitative growth machine started stuttering, then it stopped all together, and previously balanced, measured debt burden spiraled out of control, unemployment, social tension started rising exponentially and those processes still continue to worsen.
    What we still stubbornly ignore is that constant quantitative growth is simply impossible, since we exist in a closed, finite and very finely balanced natural system.
    Our artificial, unnatural lifestyle, socio-economic system has exhausted itself and no miracle cure, magic solution can revive it any more.
    Both humanity and the natural environment has a lot more to offer, the planet is capable of supporting normal, healthy lifestyle for much more than 7 billion people, but in order to do that we need to return to the general balance and homeostasis every integral, natural system is based on.
    We have to re-educate ourselves about global, integral systems, about the fundamental laws of nature and adapt to our environment as any other living organism would do in order to survive.
    The system is not going to change, it is infinitely larger and stronger than humans. Only we can adjust ourselves and adapt.

  5. Portrait of Michael Heller

    CommentedMichael Heller

    Michael: This is an excellent, timely, and balanced article in my view. Only one thing was not made explicit - the private sector will need government help in order to respond to the deleveraging cycle. Structural adjustment (removing obstacles to growth) inevitably has this (very tough) institutional dimension. But your discussion will sharpen minds among reluctant reformers and deluded money magicians. It is good to have contested facts confirmed -- the debt was misused; exit from excessive debt inevitably mean less demand, less growth, and more savings; nothing will be achieved by deleveraging alone; there are big risks and limits to what central banks can do; and burden-sharing solutions require real compromise.

  6. CommentedMatt Stillerman

    Pardon me, but this is precisely what they have NOT shown. Once the flaws in the R&R paper are fixed, what remains is a modest negative correlation between public debt and GDP growth. The paper does not say, and R&R have explicitly disavowed that they have shown, that large debt causes low growth.

    That there is such a correlation is not at all surprising. Others have presented evidence that supports the causality going in the other direction--that low growth causes higher public debt. What's more, this is far more plausible as an explanation of R&R's data.

  7. CommentedMark Pitts

    Great article, especially in showing that every unhappy family (i.e. indebted country) is unhappy in its own way.